What is a floating rate fund?
A floating rate fund is a mutual fund or exchange-traded fund (ETF) that invests in debt instruments whose interest payments vary with an underlying short-term benchmark rate. Instead of fixed coupons, the interest on the fund’s holdings resets periodically (for example, monthly or quarterly), so the fund’s income tends to rise when market interest rates rise and fall when rates decline.
How floating rate funds work
- Holdings: These funds typically include floating rate loans, floating rate bonds, bank loans, and sometimes preferred stock or asset-backed debt. Maturities are often short to intermediate (commonly months to a few years).
- Coupon mechanics: Instruments in the fund pay a rate tied to a benchmark (historically LIBOR, or other short-term reference rates) plus a fixed spread. As the benchmark moves, the coupon paid to investors adjusts.
- Seniority: Many floating rate loans are senior secured debt, meaning they have higher claim priority in a borrower’s capital structure. Seniority affects recovery prospects in default but does not guarantee credit quality.
- Income distribution: Funds pass income to shareholders through regular distributions, which may include interest income and sometimes capital gains.
Benefits
- Lower interest-rate sensitivity: Because coupons reset, floating rate funds are less exposed to duration risk than fixed-rate bond funds. They tend to perform relatively better when interest rates are rising.
- Income that reflects current rates: Coupon resets allow the fund’s yield to more quickly reflect prevailing short-term rates.
- Diversification and access: These funds offer diversified exposure to a broad mix of floating-rate debt without requiring large capital outlays to buy individual loans or bonds.
Risks and limitations
- Credit risk: Floating rate funds can include lower-credit-quality issuers and loans that carry default risk. Higher yield potential often accompanies higher credit risk.
- Market and liquidity risk: Some underlying loans and securities can be less liquid than higher-grade bonds, which may complicate trading during stressed markets.
- Not risk-free relative to Treasuries: While floating rate funds may out-yield short-term Treasuries when rates are rising, Treasuries provide greater credit safety because they are backed by the U.S. government.
- Heterogeneous exposures: Funds vary widely by the credit mix, collateral quality, and covenants of the underlying loans. Investors must review fund holdings and objectives to match their risk tolerance.
How floating rate funds compare with money market funds
- Money market funds invest in very short-term, high-quality cash equivalents and prioritize capital preservation and liquidity; yields are typically lower.
- Floating rate funds accept more credit and market risk in exchange for potentially higher yields and greater sensitivity to changes in short-term interest rates.
Examples of fund types
- Floating-rate bond ETFs: Track indices of short-duration floating-rate notes and invest in floating-rate securities issued by corporations and financial institutions.
- Short-term corporate bond funds: Although not all short-term corporate bond funds use floating coupons, some focus on short maturities as an alternative lower-duration income sleeve.
(When considering a specific fund, review its prospectus for holdings, credit quality profile, interest-rate reset mechanics, fee structure, and distribution schedule.)
Key takeaways
- Floating rate funds invest in debt instruments with variable coupon payments tied to short-term benchmarks.
- They reduce exposure to duration risk and can offer rising income when market rates climb.
- These funds carry credit, liquidity, and market risks; fund composition varies, so evaluate holdings and objectives before investing.